Tips from Tips: The Informational Content of Treasury Inflation-Protected Security Prices

Abstract

We examine the informational content of TIPS yields from the viewpoint of a general 3-factor no-arbitrage term structure model of inflation and interest rates. Our empirical results indicate that TIPS yields contained a "liquidity premium" that was until recently quite large (~1%). Key features of this premium are difficult to account for in a rational pricing framework, suggesting that TIPS may not have been priced efficiently in its early years. Besides the liquidity premium, a time-varying inflation risk premium complicates the interpretation of the TIPS break even inflation rate (the difference between the nominal and TIPS yields). Nonetheless, high-frequency variation in the TIPS break even rates is similar to the variation in inflation expectations implied by the model, lending support to the view that TIPS break even inflation rates are a useful proxy for inflation expectations.

Keywords: term structure model, inflation expectation, inflation risk premium, SPF, Treasury Inflation-Protected Securities (TIPS)

JEL Classification: G12, E31, E43